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Module 5 - Horizontal Links and Moves
5.2 The Diversification Game
The conglomerate corporate strategyis characterised by diversification into new and unrelated business.
Diversification is both a di rect ion and a method. It is a di rect ion because the firm expands along particularhorizontal lines and a methodbecause the firm exploits these opportunities through internal organisation ratherthan through agreements with other firms.
5.2.1 Horizontal Directions in the Diversification Game
Diversi f ication game seen from firm 3s perspective:
1
6
5432
10987
Helmets Trousers Jackets Handbags Umbrellas
Motor cycle Motor cycleMotor cycle Accessories Accessories
Carbon-fire Leather Leather Leather Plastics/metals
Market
Technology
The question is how Firm 3 should choose. Three rules which may help:
Rule 1: Competi t ive advantage: Each player must seek competitive advantage over the other. In our simplegame we assume particular moves may enhance competitive advantage in one of two ways; the move must helpshift at least one demand curve or one cost curve in a way that adds value to the firms activity. Diversified firmsdo not compete; only their individual business units do. If diversification is to have benefits it must be in terms of apositive impact of the ability of at least one of its businesses to compete in the market place.
Rule 2: Only on e move at a t ime: It is expensive to diversify at all levels
Rule 3: Fair play:Here fair play is interpreted to mean that a particular move does not allow a firm to achieve adominant position that would allow them to exercise monopoly control over customer or suppliers.
Each move has different implication for competitive advantage.Firm 3 merging or acquiring firm 8the specialisation shown below
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The value chain and gains from specia lisat ion:
Distribution
Marketing
Production
R&D
D
M
P
R&D
sales force
trucks
marketing developmentmarket researchadvertisement
plant
equipmentlabour force
research
development
Firm 3 mergers with... Firm 8
Partial l inks between the value chains in the case of both helmet and handbag moves:D
M
P
R&D
D
M
P
R&D
Firm 3 plus Firm 6
The MC market
D
M
P
R&D
D
M
P
R&D
Firm 3 plus Firm 9
Leather technology
= Marketing and distribution linkages
= Technological linkages
Good f i ts between both value chains in the case of jackets to trousers:
D
M
P
R&D
D
M
P
R&D
Firm 3 plus Firm 7Leather MC garments
Leather technology
The MC market
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Strong l inkages throughout the value chain in the case of specialisation:
D
M
PR&D
D
M
PR&D
Firm 3 plus Firm 8
Leather MC jacketsLeather technology
The MC market
Jackets to umbrellas a conglomerate type move generate no real linkages:
D
M
P
R&D
D
M
P
R&D
Firm 3 plus Firm 10
Jackets and umbrellas
5.2.2 Preferred Moves in the Diversification Game
What to prefer? The firm should specialise as far as possible if it is seeking competitive advantage. There are fourmain reasons for this:
1. Resource effects. Specialise if you can; if you have to diversify, stay as close to home as possible andtry to avoid unrelated diversification as long as related alternative exists.
2. Market p ower c onsiderat ions. If the firm is seeking more control over its market, the specialisationoption is clearly the most direct and powerful route to achieve this.
3. Allergic reactions. Firms can display an adverse reaction to new activities that are unrelated or looselyrelated to its existing competencies. Failure of synergy in corporate expansion, Michael Porter - it is oftenwhat firm knows rather than what they do not know that can be the problem.
4. Rivals valuation. For example firm 4 value firm ten more than our firm 3.
5.2.3 Methods of Expansion in the Diversification Game
Why should the firm choose expansion by diversification as a method of expansion opportunities rather thanmaking some agreements with the firms to share resources?
Market power is one example. You may not trust your partner. Resource effects may be achieved by co-operationas well as by diversification. The reason why firms diversify in some case is the transaction cost associated by co-operation. The opportunity cost is also a reason for going the conglomerate way.
5.3 Why Diversify?
5.3.1 Market Power
There are many ways that power could be exercised by diversification, but each tends to come down to theincreased share of the firm in particular markets.
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How divers i f icat ion c an aid contro l of markets and technolog ies:
D
M
PR&D
D
M
PR&D
D
M
PR&D
D
M
PR&D
Leather technology link
The MC market link
Helmets Trousers Jackets Handbags
5.3.2 Synergy
If resources can be shared across value chains for different businesses they may give rise to cost savingsdescribed as synergy in strategic management and economics. If the businesses are effectively the same these
resource affects are described as economies of scale. There can be two sources of gains in such cases:
Indivisibi l i t iesResources tend to come in lumps a factory, a truck, a machine, an economist, etc. Ifyou where to cut each of these resources in two physically, they would not be able to do their job anymore. The fuller the use that can be made of these indivisible lumps, the lower will the cost to the firm ofusing these resources.
Special isationExpansion of the firm may permit increased specialisation of resources which in turncan lead to enhanced value for the combined firm.
Economicshave traditionally focused at the level of individual productslike a jacket or a helmet and looked atcost and price considerations in the respective cases.
Strategic managem entfocuses instead at the level of the individual firm and looks at the resource questions thatmatter at this level. The bigger and the more diversified the firm, the less likely that economies from sharingtangible resources such as plant and equipment are going to be important at the level of corporate strategy, andthe more likely that intangible resources such as managerial capabilities are going to be of relevance.
5.3.3 User Gains
Diversification can also help generate competitive advantage for the diversifier by providing benefits for the user.These gains tend to be reflected in one of two main ways:
Cost advantage:e.g. one stop shopping with the convenience of one supplier of M/C goods to retailersrather than three.
Differentiat ion: e.g. enhanced compatibility of products, with M/C jackets, trousers and helmets in
matching styles
5.3.4 Internal Markets
The diversified firm is in a position to create internal markets such as internal labour markets, internal markets forR&D know-how or know-how in general, and so on. The form of transaction cost depends on the case in point,but the advantages of internal markets over external markets are generally regarded as having tree majorsources:
Asymmetr ic in format ion managers inside the firm will generally have access to more and betterinformation about the potential trade than outside individuals and organisations.
Contro l of opportun is t ic behaviouris easier from the inside
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Divisional isation gains- The growth of the diversified firm has been seen by some as creating possibleefficiency gains in terms of organisational structure. Instead of organising the firm around functions inwhat has been termed a Unitary form or U-form structure, the firm could now be organised arounddivisions in a Multi-divisional or M-form structure.
The major advantages that M-form structures have been identified as having over the U structures for thelarge diversified firm include:
o The creation of profit centres to aid assessment and comparison of performanceo Putting together resources that have the most need to co-ordinate their activities into natural unitso The separation of strategy formulation management responsibilities at headquarters level in the
firm from the functional responsibilities at divisional level
The disadvantages in substituting external markets with internal markets, especially in terms of principal-agentproblems in which the shareholders are the principal and management are the agents:
Opaque performanceA problem with creating an internal market is that it reduces the transparency ofperformance since the performance of divisions may be concealed within consolidated accounts at helevel of the firm
Lock- in One of the great virtues of the market mechanism is its flexibility. Opportunity costconsiderations mean that assets have negative value in their present use, the market mechanismprovides very effective devices for reallocating assets to their best uses. Internal markets can be stickier.For instance, one product can be dependent on the other, otherwis e it wont be profitable.
Not invented heresyndromeDivisions may place more value on ideas developed by themselves andless on ideas developed elsewhere, even if these ideas have been developed by other divisions withinthe same company.
One of the most widely considered markets in the context of the diversified firm has been the internal capitalmarket. By throwing corporate boundaries around the various businesses operated by the conglomerate, it wasargued that this would allow the firm to avoid the transaction costs associated with the blunter and less sensitiveinstrument of the external capital market, these firms remained independent, smaller and more specialised.
Conglomerate could exploit advantages in terms of information, control and divisionalisation from treating the firmas a mini-capital market.
If it works well for conglomerates it work even better for related diversification. The internal capital marketjustification for the conglomerate is a justification of the conglomerate as a method. Essentially it says that incertain circumstances internal markets are more efficient than external markets, so if you have to choose betweenthe conglomerate and a series of independent firms, you might be better of with a conglomerate.
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Diversi f ication and creation of internal mark ets:
D
M
P
R&D
D
M
P
R&D
D
M
P
R&D
D
M
P
R&D
The related diversifier
can exploit a variety of
linkages in its internal
markets
Helmets Jackets Handbags
D
M
P
R&D
D
M
P
R&D
H.Q
DIV 3DIV 2DIV 1
H.Q
DIV 3DIV 2DIV 1
Organisational structure
for the related diversifierto help create internal
capital markets
The conglomerate
strategy exploits only
financial linkages in its
internal market
Umbrellas Helmets Fast food
Similar (divisionalised)
organisational structure
for the conglomerate
5.3.5 Growth
One frequently cited argument for diversification runs as follows: because of separation of ownership and controlasymmetric information, there is typically a principal-agent problem with manager having some discretion overpursuing their objectives at the expense of owners objectives.
Owners would normally wish to maximise profits, but managers wish the firm to grow. Therefore, managers maychoose diversification for growththat may be why conglomerates grows.
5.3.6 Risk and uncertainty
Diversification can reduce risk in many contexts. If the management of a single-business firm is worried about itsdependence on the fortunes of one business it might consider diversifying into other business to spread risk.There are two sets of problems as follows:
Opportun i ty cos t of d ivers i f icat ionDiversification moves the firm away from its core business andcompetencies. It may turn out to be a mistake once opportunity cost considerations is taken into account.There may be cheaper ways to dealing with risks.
Owners may spread the i r r isks by divers i fy ing the i r por t fo l ios
The important issue in each case is to identify which, if any, problems are caused with volatile sales this may be
solution to reduce risk: Liqu id assets(assets that may be quickly realised by the firm)firm could set aside funds for dips
Short-term financethe firm may not even have to keep a fund in the form of liquid assets if presentingthe variation for a bank. They get short-term credit
Stockhold ingKeep the production on the same level
Insuranceit may be possible to transfer the risk to insurance company
Long-term contractsis a way the firm could pass on the risk of variability,
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Vertical integration can be a way to reduce risks and guarantee sales.
None of these solutions is free. Another risk is if a rival come up with improved technology and our sales goesdown. A strategic bomb is shown. When external threats hit a firm they may not focus just on individualbusinesses, but on particular linkages. For example, if Firm 3 merged with Firm 8 above it will be able to extractgains from marketing/distribution and technological linkages.
The linkages that can help generate enhanced value when the environment is relatively stable can also pose asource of joint weakness when the environment begins to throw up nasty threats. For example, if the M/Cbusiness begins to decline, then both jackets and trousers could be attacked along the M/C market linkage. If arival develops an improved synthetic substitute for leather, then both jackets and trousers can be attacked alongthe shared technological linkage.
Corporate diversification can help provide a basis for defending the firm against unpleasant surprises such astechnological innovation by its competitors. However, there are further questions we can ask of this strategy; it isnot going to be let off so easily:
Why no t specia l ise unt i l you are forced to change to another business? Diversification usuallytakes time and costs a lot, so when it has to it may be the worst timing
I f some corpo rate diversi f ic ation is designed to safeguard m anagerial jobs , can this also be inin terest of owners? It can be on very special occasion for instance where the alternative would bebankruptcy or an alternative to loosing the best and necessary resources.
I f r isks su ch as technolog ica l innovat ion by com pet i tors are often one off surpr ises, how canmanagement know in advance when they should d ivers ify? This is impossible to answer- Goodstrategic management may find indications or warnings
On the face of it, conglomerate diversification offers the most obvious way of anticipating threats to the viability ofindividual businesses.
5.4 Forms of Diversification
Firms diversify for a number of reasons. These include market power, resource effect, user gains, creation ofinternal markets, growth motives and dealing with the possibility of attacks on the viability of individualbusinesses. Most motives suggest that the firm should stay as close to home as possible.
Related l ink s trategy(Richard Rumelt Harvard Business School) is when firms simultaneously exploit the gainsfrom the linkages between businesses together with risk-spreading benefits of multiple markets and multipletechnologies that the conglomerate strategy offers.
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New game:
6
3
109
HelmetsMC Audio
equipmentJackets Handbags Umbrellas
Motor cycle Horse ridingMotor cycle Accessories Accessories
Carbon-fire Leather Leather Leather Plastics/
metals
Market
Technology
11
14
12
15
Motor cycle
Electronic
13
16
Fast food
Restaurant
Retailing
Saddles
Some moves Firm 3 can make in game 2
MC jackets pursu es m arket-based divers i f icat ion, explo i t ing sel l ing and distr ibut ion l inkages:
DM
P
R&D
DM
P
R&D
DM
P
R&D
Helmets Jackets Audio
Here MC jackets becom es a conglom erate, moving in to new m arkets and technolog ies:
D
M
PR&D
D
M
PR&D
D
M
PR&D
Umbrellas Jackets Fast food
Technology based divers i f icat ion MC jackets explo i ts product ion and R&D com petencies:
D
M
P
R&D
D
M
P
R&D
D
M
P
R&D
Handbags Jackets Saddles
The related-l inked strategy; here MC jackets explo i ts different l inkages in its m oves:
D
M
PR&D
D
M
PR&D
D
M
PR&D
Helmets Jackets Handbags
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The most important attacks in real life corporate battles tend to be the following: Innovationin from of new products or processes Change in cons umer tastes Change in government restr ic t ion Resource depletion,an industry can simple begin to run out of raw material. Resource depletion is likely
to be a slow ticking bomb at worst with firms usually having plenty of time to prepare for the worst.
How much damage can a simple bomb do? The answer depends on the patternof linkage, not just the extent oflinkages.
Market bombs can be dangerous to firms that are diversified and market related. Technology bombs can bedangerous for firms that are diversified and technological related. Technology and market threats do not affectthe firm as a whole if it is a conglomerate thats one favour for the conglomerate.
Growth using re la ted- l inked stra tegy:
D
M
PR&D
D
M
PR&D
D
M
PR&D
Helmets Jackets HandbagsD
M
PR&D
Umbrellas
Related-linked expansion; now no more than two of the
firm's businesses are vulnerable to any threat to specific
competencies
By the figure above, a single bomb could only impact on two of its four businesses even if it were aimed at acompetence and not a single business.
This is a degree of insulation from external threat, which is almost as good as the conglomerate, and indeed themore that the related-linked firm expands using this strategy, the closer it approximates the degree of protectionoffered by conglomerates.
But it is not a conglomerate since every business is linked to every other and there is a solid level of linkageexploited as we move through the strategy, just as in the case of the market-based and technology-baseddiversifiers. This is a strategy that seems to enable management to exploit the advantages of relateddiversification without incurring the dangers of exposure to a single external threat.
The related-linked strategy is one of the unsung successes of corporate diversification. Rumelts study found thatit had been adopted by many of the most successful large firms in the US economy since the nineteen-sixties.
Conglomerates usually do not exist for synergy, deep pocket, market power reasons, or to absorb the risks toindividual businesses. Anything the conglomerate can do in these respects, related to diversification can matchand improve on. Answers to the riddle of the conglomerate must lie elsewhere and include the following:
The disguised related-l ink fi rm: many firms which appears to be conglomerates because of the diversityof their businesses turn out on closer inspection to be related-linked firms rather than genuineconglomerates.
Restructur ing of re lated-l inked f i rms:Related linked strategy can be fragile and it does not take muchto turn into a conglomerate, especially if the firm is under pressure to divest loss-making businesses.
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D
M
PR&D
D
M
PR&D
D
M
PR&D
D
M
PR&D
If a related-linked firm decides to divest
loss-making businesses that act as
connectors to the rest of the firm
D
M
PR&D
D
M
P
R&D
D
M
P
R&D
D
M
P
R&D
D
M
P
R&D
...then it may turn itself into
a conglomerate by default
No alternatives:There are some industries which have faced external threats in the past for which it hasbeen difficult to find closely related products. Tobacco and petroleum are two cases in point in whichattempts to expand and escape from a threatened industrial base led the firms into unrelated fields whenvalue-enhancing related opportunities proved difficult to find.
Rapid grow th:Synergy takes time and patience to release. If the firm is seeking really fast growth ratesin the immediate time period and the capital market is willing to bankroll your plans, then synergy is lessimportant. Strategic planning can become dominated by availability of acquisitions rather than how they fitexisting businesses. This is how many acquisitive firms in the past turned into conglomerate.
Path dependenc y: Restructuring, the absence of alternative and rapid growth may explain why somefirms become conglomerates but they do not help explain why they remain such. One answer is the pathdependency. The managing skills in the firm may be built on managing unrelated businesses and shifting
strategy involve a major change among top management skills and substantial transaction costs in buyingand selling business until the new strategy is created.
Conglomerate focus:Management learn and adapt. They may not be able to change their spot easilybut they can do the next best thingthey can shuffle them around.
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Downsiz ing and conglom erate pers is tence:
D
MP
R&D
D
MP
R&D
D
MP
R&D
D
MP
R&D
This conglomerate has been hit by
threats to two of its businesses...
D
MP
R&D
...so it has divested these loss makers
and instructed the three ramaining
groups to diversify into related fields
D
M
PR&D
D
M
PR&D
D
M
P
R&D
D
M
P
R&DD
M
PR&D
D
M
PR&D
Vertical integration is unlikely to be a successful long-term solution for a firm in a declining industry.
Decline in unit cost with cumulative production is the definition of the learning curve
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Module 6 - International Strategy
A company is internationalif it serves foreign markets. It is mul t inat ionalif it also locates facilities abroad.
John Dunnings studies discovered that most of the worlds giant companies had the majority of their sales in theirhome domestic market and located the most of their assets, including factories, in their home country. Since thestudy (1993) the internationalisation and multinationalism is growing especially for giant companies.
It is not necessary to be highly multinational (or indeed even very international) to be an extremely successful
company. If this holds at the level of the world's largest companies, it holds even more strongly for small andmedium-sized companies where the tendency to stay close to home base is even more prevalent.
6.1 The Diversification Game Goes International
A major problem with diversification was that it could lead to the sacrif ice of the rich resource linkages which maybe possible under specialisation. Though, it could have the possible advantage of saving the firm fromoverdependence on a limited set of competences that may be vulnerable to obsolescence.
Resource impl icat ions of d omest ic versus m ul t inat ional expansion:
Firm 3...multinational expansion... Firm 8
D
M
P
R&D
Distribution
Marketing
Production
R&D
Distribution
Marketing
Production
R&D
research
development
Firm 17 ...and domestic expansion...
sales force
trucks
marketing dev.market researchadvertisement
plantequipment
labour force
Multinational is quite simply a bad deal in terms of resource linkages, certainly compared to the domesticspecialisation option. If our manufacturer of motor cycle jackets were to export to this foreign market, thenexporting would allow the concentration of production in the home base and possible exploitation of economies ofscale in production.
Even if the firm can exploit few physical economies of scale from further expansion of production, there shouldstill be administrative economies compared to the alternative of having to administer separate production facilitiesin different countries as in the multinational alternative.
Resource costs such as cheap labour in the production process could encourage the jacket firm to relocate itsproduction to an overseas location. Transport cost might seem to be an argument against exporting and in favourof saving on transport costs and locating production near foreign markets through multinational expansion.
However, transport costs tend to be important in cases where a product takes up high volume or significantweight in relation to value added. While transport costs undoubtedly exist they are not sufficient to explain whysome firms choose to fragment and disperse their production capabilities into a variety of different locationsscattered around the world.
It is not enough to establish international opportunities to justify international expansion. These opportunities willonly be worth pursuing if they beat alternative domestic investment opportunities, taking into account the ability ofthe firm to compete against foreign firms on their home ground.
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Resource impl icat ions of m ul t inat ional versus export ing stra teg ies:
Firm 3...multinational enterprise...
D
M
P
R&D
Distribution
Marketing
Production
R&D
Distribution
Marketing
Production
R&D
research
development
Firm 17 ...and exporting
plantequipment
labour force
6.2 The Question of International Competitiveness
In his Competitive Advantage of Nations, Michael Porter (1990) makes some crucial points about the idea ofcompetitiveness of industry seen from a national perspective:
Is compet i t iveness o f industry based on exchange rate? Is compet i t iveness b ased o n cheap labour? Is compet i t iveness based on cheap natura l resources?
The basic point that Porter is making is a sound one, that it may be simplistic and indeed misleading to identify acheap currency or cheap resources as necessary or sufficient for competitive advantage. If low cost is notnecessarily the only or even the best strategy for firms to achieve competitive advantage, we should not besurprised to find that the same holds at the level of countries.
Portermakes the point that we have to be careful in using the notion of competitive advantage at the level ofcountries at all. He argues that countries do not compete, firms do. Firms inside a country may often identify theirfiercest and most direct competition in that domestic market place.
For a given country , there are typ ica lly few indus tr ies or segments of indus tr ies, which perform,strongly in an internat ional context . For a given industry , or especia lly segments o f industry , there are typ ical ly few countr ies wh ich
perform strong ly in an internat ional context
For example, there is a general belief that the Japanese are so efficient that they can beat firms from most othercountries at any activity they care to turn their hands to. In fact, their international success is quite concentratedin a selective number of highly visible industries such as automotives and consumer electronics. There are otherareas where Japan has not been so internationally successful, such as the food and advertising industries.
There are only a few countries that are internationally successful in the automotive industry, and the numbers thathave a major international presence dwindle when we look at sectors within each industry. We may have toquestion received wisdom about the sources of competitive success if we are to understand the sources ofinternational competitiveness.
Consider this dilemma, you are a maker of widgets choosing between producing and selling in CountryA or Country B, the countries differ in the characteristics indicated as far as your business is concerned. But aresimilar in all other relevant characteristics such as size of domestic market and access to capital.
Where to compete: soft versus tough environments
Country A Country BFirms You would be the only firm Many fierce and capable rivalsConsumers Easy to please, undemanding Well informed and sophisticatedGovernment Lax regulations and controls Tight regulations and controlsFactors Abundant and cheap resources Scarce and expensive resources
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Simple textbook economics suggests that it has to be Country A. However, when we look at firms that areinternationally successful in practice, they frequently come from countries with some or all of the characteristics ofCountry B. In fact, Michael Porter goes further and claims that they may be more likely to come from countrieslike B than countries like A.
It would be dangerous to believe that a single element is behind competitive success in these industries. Indeedit will tend to be a combination of elements that contributes to international competitiveness or failure at industrylevel. In fact, there are two issues at work here, and we can summarise them as space and time.
Standard economics tends to look at firms and sectors in isolation, but sometimes issues in other spaces orterritories can be very important. Major technological and organisational upheavals and transformations tend tolie too far in the distance to be dealt with by standard economic tools.
The problem is that it is the longer time dimensions that can be associated with the forces which may create andsustain competitive advantage and which we need to look at in this context. Today's comfortable monopolist maybe tomorrow's bankrupt firm.
6.3 Porter's Diamond Framework
Michael Porter argues that competitive strategy for a firm should be framed in the context of the attributes of itsnational environment that may help generate or inhibit competitive advantage. These attributes fall into four maincategories, which together go to make up -
Porters Diamond Framework:
1. Factor condi t ions
2. Demand condi t ions
3. Linked and related indus tr ies
4. Firm strategy, struc ture and rivalry
The important driving forces of the Diamond can be analysed in terms of: Space considerations.The space covered by the relevant Diamond is essentially contained within the
home base (usually the nation) to which the firm belongs. An important unit of analysis here is the cluster(a group of firms in linked or related industries that trade or compete with each other). A cluster typicallyoccupies an even more localised space than the nation state, and in practice may be found within
regions, cities, districts or even single streets.
Time considerations. Time or dynamic considerations reflect the fact that the normal logic ofcompetitiveness may be turned on its head once we look at the time long enough to allow for majorinnovative and organisational changes.
(A) Factor condit io ns
These can have a critical influence on competitive advantage. Porter distinguishes between factors in term of: Degree of sophistication.At one end of the spectrum we have basic factorswhich tend to be inherited
(natural resources) or easily created (unskilled labour) and at the other we have advanced factors(research scientist) which are more sophisticated.
Degree of specialisation.At one end of the spectrum we have generalised factors which can be turnedto many different kinds of tasks (village hall). While at the other end we have highly specialised factorswhose value lies in a limited set of tasks or one specific task (brain surgeon).
One of the most important issues that Porter introduces in this context is the notion of selective factord isadvantage. It occurs when scarcity or other problems of a certain factor stimulate technological ororganisational innovation to deal with the problematic factor, and this innovation turns out to help generatesubsequent competitive advantage in an international context.
Examples of Selective factor dis advantages:
Japanese language Fax technologyDistances in US Communications and transport innovations
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Short Swedish building season Prefabricated technology
In each of these cases there was a factor disadvantage which created immediate costs or barriers to industrialactivity and triggered a search for innovative solutions. These solutions not only alleviated or neutralised theoriginal source of disadvantage, but turned out to be a source of international competitive advantage. Theopposite is also possible in some cases.
Factor disadvantages, including scarcity, can turn out to stimulate eventual competitive advantage while factoradvantages, including abundance, can eventually lead to declining competitive advantage. The problem is that
not all sources of factor disadvantage turn out to have this eventual benign effect, any more than factorabundance need turn out to be an eventual source of declining advantage.
(B) Demand cond it ions
The home market may dominate in terms of the quant i ty of information feeding back into the framing ofcompetitive strategy. But it may also be important in terms of the qual i tyof the information that feeds back intothe planning process. If those involved in the formulation of strategy are based in the same country as the firm'sheadquarters and home market, they are likely to be heavily influenced by the characteristics of that domesticmarket.
Porter argues that there are three main features of demand conditions that can be important in a dynamic contextin terms of helping develop and reinforce competitive advantage:
1. Composition of home demand. The composition of home demand can provide pressures andopportunities since the signals coming from home demand can be clearer than weaker signals comingfrom foreign markets. The main issues here include:
i. Segment struc ture of demand:the distribution and variety of patterns of demand within a sector.ii. The existence of soph ist icated and demanding b uyers:sharpening up and honing the competitive
skills of firms that could prove useful in competing with firms that have had an easier life.iii. Ant ic ipatory buyer needs:providing an early warning system and experience of trends that may
emerge in the future in foreign markets
2. Demand size and pattern of growth : there are a number of features here that can reinforce the effectsof home demand composition on competitive advantage:
i. Size of hom e marketcan help generate economies of scale and learning curve effects.i i . Numb er of independent buyers, includ ing at wh olesale or retai l levelscan generate variety of
information and market feedback, and reduce the chance of inertia for firms that attend to this sourceof information.
iii. Rate of growth of market demand: advantages of a growing market include possible entry room forinnovative new firms - otherwise incumbents may have an inbuilt advantage if the customer basedoes not change and expand.
iv. Domestic m arket saturates early:this may stimulate fierce rivalry amongst domestic firms that canenhance cost competitiveness and innovativeness and in turn enhance their fitness to compete on aworld stage.
3. Internationalisation of home demand. These aspects can help pull a nation's products abroad.
i. Mobi le or m ul t inat ional buyersmay seek to buy or be receptive to buying the products that theyconsumed at home
i i . Influence on foreign needs: historical or cultural factors may influence.
(C) Linked and relat ive industr ies
Internationally competitive industries and sectors tend not to emerge in isolation but instead are associated withother internationally competitive industries within their nation or region. These industries or sectors may be linkedvertically or horizontally to each other.
Linked and related industries can exert a strong influence on the competitive advantage of a sector throughproximity of innovative and enterprising companies in neighbouring sectors. Competitiveness and high
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performance in one sector can have spill-over benefits into linked and related sectors in the domestic marketthrough a variety of means: User sector firms imposing high specifications on supplier sector Reputational spill-overs User sector firms demanding cost competitiveness from supplier sector Supplier sector protecting their brands by raising user sector performance Technology spill-overs between related sectors Related sectors sharing marketing and distribution channels Spill-over of highly trained and well-qualified labour pool between sectors Best practice diffusion by example and observation Proximity reduces transaction costs between sectors
The fundamental point is that sectors may benefit in a variety of ways that enhance performance or reduce costsfrom having an internationally competitive sector nearby.
(D) Firm s trategy, structure and rivalry
Important themes in this context include the following.1. Strategy and structure of dom est ic f i rms. As an example of this, Porter argues that the value placed on
technical skills in Germany has helped create and support its competitive advantage in optics and somechemical and machinery sectors.
2. Goals and objectives. These can be important at the level of the individual, the company or the nation, and
can be heavily influenced by the cultural context. For example, Porter notes that Germany has a tradition oflong-term holding of shares by institutions and a more cautious approach to risk taking. The US has a culturethat tends to encourage the taking of risks and therefore place a strong emphasis on start-ups, such asbiotechnology.
3. Domest ic r iva l ry. This is one of the most important aspects in the Diamond Framework. When the industrialstructures of internationally competitive industries are dissected, it often turns out to be based on strongdomestic rivalry between firms. (Example, Volvo/Scania)
(E) The jokers in the pack: chance and gov ernment
Porter adds that both chance (e.g. wars and inventions) and government can play roles in the relationships,which evolve in the Diamond in the context of creating an international competitive advantage.
6.4 Using the Diamond Framework
6.4.1 Identifying and Using a DiamondSome of the issues and difficulties that are raised in using a Diamond approach:
6.4.1.1 Interdependence of the Fou r Main Elements. An essential feature of the Diamond is that no oneelement can be isolated as 'the' element that has (or will) create competitive advantage for a sector in aparticular country. In practice, a number of elements will contribute and interact with each other.
6.4.1.2 Essential Contr ibut ion of Al l Four Main Elements. Porter argues that each of the four main categoriesin the Diamond should usually actively contribute to competitive advantage if it is to be generated andmaintained. Though, just as it may be possible to have a three-legged chair in certain cases, so the
absence of a strong fourth leg can sometimes be compensated for. But, just a two-legged chair isimpossible.
6.4.1.3 Con tinuo us upgrading and improv ement. The Diamond uses just snapshot and are static, in realworld it does not work so.
6.4.1.4 Subjectivi ty and Mult ip l ic i ty. The Diamond reflects an art rather than a science, different people mayconstruct the Diamond differently.
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6.4.2 Diamond in Action: US Competitive Advantage in Economics Textbooks
(A) Factor
condi t ions
(B) Demand
Condi t ions
(C) Link ed and related
industr ies
(D) Firms strategy,s t ructure and r iva l ry
Leading authors Large domesticmarket
Advertising and softwareindustries
Advertising-oriented
English language Anticipates widertrends
Glamorous industry
Major university Sophisticated
distribution channels
Risky venture
Numerous rivals
6.5 Framing Competitive Strategy
Porters Diamond has a number of implications for company strategy.
1. Possibility of competitive advantage depends on home Diamond
2. Choice of strategy influenced by home Diamond
3. Continuous innovation. The diamond needs continuous upgrading and improvement to maintaincompetitive advantage. To survive and maintain competitive advantage from innovation pressure Porter
suggests: Seeking sophisticated buyers Seeking buyers with most demanding needs Overshooting most stringent regulations or standards
Sourcing from leading home based suppliers Seeing leading rivals as benchmarkingSuch solutions do not guarantee competitiveness
4. Perceiving and anticipating industry changeThe diamond can help a firm position its strategy with futureopportunities and threat in mind. Porter suggests a variety of ways in which this may be pursued:
Seeking buyers with anticipatory needs
Exploring emerging buyer groups Seeking locations with early regulations
Identifying trends in factor costs Linking with research centres Studying new competitors Having outsiders in the management team
But an uncritical emphasis on emerging signals and apparent trends can be dangerous (Ex. Dot.com)
5. Difficulties of replicating a Diamond advantagesPorters analysis helps to illustrate how difficult it maybe to replicate the advantages that a foreign Diamond may give its local firms
6. Awareness of foreign Diamonds The bottom line is that firms should be aware of their merits anddeficiencies of their Diamond and those of their competitors when framing their competitive strategy.
6.6 Competing in International Markets
What does it take to compete effectively in international markets? We can approach this problem by using whatDunning (1993) has called the Eclectic Paradigm. This suggests that multinational enterprise is a consequenceof ownersh ip advantage, internal isation advantageand location advantage.
If foreign firms had no ownersh ip advantage, they would find it difficult to play away from home againstlocal firms and their home advantage. However, there are other kinds of ownership advantage that maybe drawn on to help support competition in an international environment, these include:
o marketing know-how and resourceso organisational advantageso access to financeo purchasing know-how
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o favoured access of resources (e.g. ownership of oil reserves)o brand recognition (e.g. McDonalds)
If there were no location advantages, firms would find it attractive to service global markets from onecentralised base. There are a variety of possible influences that may encourage a firm to locate some ofits activities overseas, including:
o access to cheap or high quality resourceso transport costso need to service local market quicklyo to learn from the local Diamond or increase sensitivity to local market requirementso government impediments to imports (e.g. tariffs, quotas, non-tariff barriers).
If there were no internal isation advantages, licensing local firms could appear as an obvious alternativeto multinationalism. Such advantages include:
o search costs for a suitable partner to co-operate witho negotiation costso policing costso lack of able and suitable local partnerso residual problems of opportunistic behaviouro reducing vulnerability to fluctuations and uncertainty of external variableso control over secrecy of ownership know-how advantages (intellectual property)o control over brand imageo problems of controlling delivery, quality of inputso reducing chances of losing access to inputs or outletso being able to indulge in monopoly practices such as a predatory pricing using transfer pricing and
cross subsidisation
Ownership, location and internalisation advantages are all necessary for multinational enterprise to exist inparticular cases. Take away one element and another strategy becomes more effective. Indeed, the fact that wedo observe some domestic firms competing successfully in their home markets suggests that foreign firms maynot have an ownership advantage in some cases.
The fact that international co-operative ventures exist between firms suggests that the associated transactioncosts of these ventures are not sufficient to give an internalisation advantage from the multinational alternative insuch cases.
International expansion will tend to become a major option after the firm has exhausted specialisation anddiversification opportunities in its home base to the point that the weaker resource linkages, associated withoverseas expansion begin to look relatively attractive. Firms first preferences are to stay at home from veryrational and sensible resource-based reasons.
6.7 Competing Abroad: The Principles
Porter (1990) suggests a number of principles that are important for firms to bear in mind if they are to competesuccessfully abroad.
Seek sop histicated overseas buyers. This is simple extension of the logic of Porters analysis of thebenefits of sophisticated home demand in a Diamond framework. If the firm also seeks sophisticatedcustomers overseas it can strengthen its ability to compete at the highest level in an international context.
Source basic factors g lobal ly. If an input is a basic standardised commodity it is easy to write a contractfor its delivery and such factors on their own are unlikely to generate sources of competitive advantagefor the firm. So there is every opportunity to outsource such factors, usually few dangers with that.
Keep strategic assets close to home. Diamond considerations and the advantage of domesticclustering for strategic resources encourage many multinationals to emphasis home locations for strategicassets such as R&D laboratories.
Select ive tapping of fo re ign technology. While transaction cost problems of potential leakiness oftechnological know-how can also discourage them from co-operating with foreign firms. These sameproperties mean that the firms may be able to pick valuable scraps of technical information through co-operating with or simply observing foreign firms.
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Attack rivals directly to learn from them and neutr al ise them. It may be tempting to avoid directcompetition with strong competitors in home and overseas markets, but Porters Diamond analysissuggests that this may be a mistaken strategy in the long run. Head to head competition can be avaluable learning opportunity to observe what generates competitive advantage for its, best rivals, andmay help inhibit these rivals from growing even stronger.
Loc ate Regional HQs at best Diamo nd. In deciding where to locate a regional HQ overseas within anation or trading bloc, an international firm should be sensitive to the possibilities afforded by localDiamond and cluster opportunities.
International acqu isi t ions and al l iances for access and learning. In spite of the downside, mergerand co-operative strategies can be useful ways of gaining access to foreign markets when all else fails orproves too expensive.
Global isation versus local isation.The world is not a homogenous entity but comprises many differentcultures, societies, legal and political systems.
6.8 Globalisation Versus Localisation
The issue of globalisation versus localisation can be best set out in resource-based terms using a value chainanalysis. The best solution for the firm in resource-based terms is what is called 'sticking to the knitting', bykeeping as close to home as possible, by staying in the same product line and the same home market.
Resource-based logic suggests that the firm should organise and manage itself the same way, try to make thesame type of product using the same technology and sell that product the same way in different world-markets.
Market-oriented logic may suggest that what works in one country may not work in another. This may haveimplications for the way the firm manages and organises itself, the technology it uses, the type of product it sells,and how it sells these products.
Can the tension between resource-based and market oriented logic be resolved? There are at least three issuesthat may still encourage the evolution of international firms, even in markets traditionally dominated by local tastesand brands:
Surface differentiat ionIt is important to dig deeper into cases where brand names differ across countries. In some cases this
may represent a product with quite different specifications from that which exists elsewhere, while inothers the brand name may be all that distinguishes the national product from that produced and sold inother countries. In the latter case, the international firm may still be able to draw heavily on itsestablished base of technical and marketing know-how in different national contexts.
Access to factors of product ionFirms may go international, not just to get access to foreign markets but to get access to cheap or betterfactors of production.
Cultural global isationTastes and preferences are not static but change and in some cases there may be some convergence.French commentators may complain about the lowering of food standards represented by the spread offast food chains. But internationalisation of brands can work both ways and may also reflect a taste for
increasing sophistication and variety of choice on the part of consumers.
The tension between globalisation (of brands) and localisation (of tastes and preferences) does represent achallenge for firms that wish to transfer their national sources of competitive advantages into foreign fields. Ifnational conditions are very different from each other, then it may be difficult to compete abroad on existingsources of competitive advantage.
At the same time, local differences may only be skin deep and a determined firm may be able to use a great dealof common technical skills and competence in marketing to compete in different national context. It is important tobear in mind that international firms may not just respond to a given set of tastes and preferences they may beable to change these national tastes and characteristics as well.
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Module 7 - Making the Moves
There may be gains to be had by comb in ing different bundles of resources and co-ordinating their activities.Strategies should only be seriously considered if it looks likely that they will deliver net gains, even after takingopportunity costs into account.
7.2 Evidence on the Performance of Combinations
One of the most surprising things about merger, acquisition and joint ventures is how badly they tend to perform
in practice, and yet how popular they remain with strategic planners. Surveys of merger and acquisition activityhave tended to conclude that, on average, there is no strong evidence that they lead to increases in profitabilityand efficiency, and indeed the evidence tends to point in the opposite direction, with merger on average reducingefficiency.
However there are some pitfalls in terms of judging whether or not a particular combination has or has not addedvalue.
Measurement diff icul t ies. How do you know if a merger, acquisition or joint venture has been a success?One would look at its effect on performance. Here the test should be on whether this combination addedvalue compared to what would have been the case if it had not take place.
However, the immediate effects are usually easier to observe and this can make it difficult to separate out and
measure the benefits from combination if they do not fully emerge until some years down the line, especially ifthese effects are lost in the wash of other merger and joint venture activity by the firm during that period.
Other mot ives. The intention may not be to increase profitability; management may pursue merger becausethey desire the status and reward that go along with a larger firm and be less sensitive to the possible effectson performance. For example, if management acquire a supplier to prevent a rival cutting them off fromessential supplies, this may not directly increase profits but could instead reduce the chances of a futurereduct ion.
Wrong cr i ter ia. Even if a combination actually adds value it may be a failure according to some criteria.Many joint ventures are deemed to be failures because they do not fully achieve their stated objective andallotted life span. However, it may be that the gains to either or both partners are not fully reflected in theperformance of the joint venture.
For example, if a co-operative agreement between an innovative firm and a firm that is strong in marketingand distribution breaks up well before its planned end date. The innovator may still have acquired valuableknow-how about selling techniques, while its partner may also have learnt something about why its formerpartner is such a good R&D performer. Both may be able to apply the know-how gained to their advantage inother activities.
Opportun i t ies cost. It is usually only possible to make limited judgements on whether or not a particularcombination has added value. The true measure of the value of a particular combination in strategic termsshould allow for the opportunity cost of alternatives forgone.
It is difficult to measure these opportunity costs in practice, but what this does mean is that where viablealternatives to merger, acquisition and joint venture have not been taken up, the true cost and real failure rateof the chosen options may be even higher than is observed and reported.
There are two important messages we should take from the empirical evidence on combination activity asfollows:a) They frequently tend to disappoint in terms of adding value, especially from the point of view of making an
acquisition and most especially from the point of view of joint venturing;
b) The strategic motives and implications of combination may be more complex than just short-term profitmaximising motives, and this may be reflected in the apparently poor performance of combinations when theyare judged in those terms.
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7.3 Adding Value from Combination
Many textbooks on strategic management contain checklists on the gains that may be made from variousmethods of trying to pursue competitive advantage such as merger, joint ventures and alliances. One checklistmay tell that merger may be useful to help obtain R&D economies, share distribution channels, transfertechnology, combine production facilities, etc, while another checklist may inform us that joint venture is useful forexactly the same things.
Competitive advantage is achieved by reducing costs or increasing market power. The first thing we need
to do in looking at the potential gains from combining resources of different business units is to produce thecorporate version. What is that combination intended to achieve? Only after that should we go on to consider themerits or demerits of alternative methods for pursuing these potential gains.
It should also be remembered that resource-based gains from combination are obtained at the level of individualresources. If we want to consider the potential impact of combination on competitive advantage then we have tolook at the level of the individual resources and activities that make up the respective value chains.
The potential gains from combination then depend on the resources at the corresponding stage on the respectivevalue chains having some similarity in terms of their contribution to activities in the chain. At this level theresources may be 'allergic' to each other (display negative synergy), just as they may generate synergy.
Synerg ies and al lerg ies from comb inat ion:
Distribution
Marketing
Production
R&D
D
M
P
R&D
sales force
trucks
marketing development
market research
advertisement
plantequipment
labour force
research
development
Firm 3 mergers with... Firm 8
Similarities and differences between
the sales forces to be combined may
lead to gains or losses
Resource gains in this case should be reflected in cost saving/productivity gains for the combination, Whether or
not those occur will depend on the current disposition and characteristics of respective sales forces and howactual changes are managed.
In particular it depends on the nature of the similarities and the differences between the two parts of thecombination, their resources and their product lines. How may these gains be achieved? There are a number ofways and they may include some or all of the characteristics below.
1. Similar outlets: eliminating duplication. If the two sales forces duplicate each other's products, territoriesand outlets, then there may be substantial gains possible from eliminating that duplication through combiningsales forces and now having only one sales representative visiting an individual retail outlet.
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2. Similar products: eliminating competition. This means that our new combined sales force may be able topush up margins on the products delivered to retailers, and worry less about price and other forms ofcompetition from a rival.
3. Similar activities: increasing sales. Suppose the two helmets are differentiatedfrom each other and havequite different brand images. The sales representatives in the combination can now represent two sets ofhelmets during each visit to a retailer, potentially increasing their sales productivity in the process. Thisrepresents both increased sales revenues for the firm in the aggregate and reduced marketing costs per unitof helmets.
4. Similar activities: improving capabilities. Suppose (before combination) one firm has superior sellingcapabilities such as superior selling practices and training methods compared to its rival. Combining salesforces may allow these capabilities to be accessed and diffused to help the rest of the combined sales forcecatch up with these superior practices, improving the quality or reducing the cost of selling. The result shouldbe reflected in increased aggregate sales revenue and/or reduced marketing costs per unit of sales.
Combining the two sets of activity and resources represented by two sets of sales force could result in a numberof potential benefits in this one category of potential resource linkage. These include:(1) elimination of duplicated activity,(2) increased control over buyers,(3) increased productivity, and(4) diffusion of superior or best practice capabilities throughout the combination.
The gains may be thought of in terms of supply-side gains (sharing resources and reducing costs) or demand-side gains (shifting demand curve and/or increased market power). The particular form the gains take will dependon the actual linkage in question. For example, increased market power here is reflected in increased bargainingpower with respect to buyers, while market power effects from combining purchasing departments could bereflected in increased bargaining strength with respect to suppl iers.
The most obvious way to achieve gains through resource sharing or enhanced market power is through merger oftwo firms, or acquisition of one firm by the other. There are two comments worth making at this juncture.
1. The whole chain matters. The point is that where the economies may be obtained through combinationdepends very much on the case in hand, for example, production or sales force.
2. Alternative methods of combining activities. Mergers and acquisition are not the only way such enhanced
value may be pursued. An obvious alternative is internal expansion. Where the benefits are built onincreased scale of output, organic growth may allow the firm to achieve the necessary size eventually withoutthe problems of integrating different systems that may be incompatible.
Where the benefits reflect reduced duplication of activity, the firm may be able to achieve the same ends byconcentrating on competing against its rival and encouraging or forcing its withdrawal from this market. Inprinciple, the intended outcomes of merger and acquisition may also be achievable through internal growth orco-operative arrangements.
7.4 Why Do Mergers and Acquisitions Perform So Badly?
If we want to explore this question from the point of view of competitive strategy, it really breaks down into twoparts.
1. Why do mergers and acquisition so often fail to realise the added value that had been promised from thecombination?2. Why does one party to the transaction (the shareholders of acquiring firms) often seem to do badly
compared to their counterparts on the other side of the transaction?The answers will tell us a lot about the nature of this method of pursuing competitive strategy.
7.4.1 Why the Gains from Merger or Acquisition May Be So DisappointingThere are a number of possible reasons for the frequent disappointments in terms of adding value.
Compatibility problemsThis is something that may be fairly obvious problem in the case of conglomerate acquisitions where the skillsbuilt up in running one part of the business are not readily transferable to other parts.
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It may also be observed in some vertical mergers where different stages may involve different skills andcompetences. These issues can also result in principal-agent problems in which the divisional managers may beable to conceal the true reasons for poor performance from corporate level management
Even firms that offer similar or identical products have their own unique identity and character, whether they arefast food chains or oil companies. This holds for human capital as well as physical capital, and for proceduresand practices as well as technical manuals.
Some of these differences may be explicit, such as specifications of equipment and materials; other aspects maybe intangible and reflect custom and practice, the way things are done. The trouble is that these latter sets ofcharacteristics may be less visible than physical characteristics, and managers may find difficulty in changingthem, even in cases where they are aware of the differences in the first place.
This has potentially at least two adverse consequences:1. The component parts may continue to go their own way and do things the way they did before the
merger. This would limit co-ordination of resources across the combined firm and mean that the new firmcould fail to achieve its perceived potential in terms of adding value by harmonising and standardisingactivities across the firm.
2. Attempts to co-ordinate and harmonise activities across the board may be costly, especially if the skillsand competence's to be transferred are not appropriate to the other parts of the firm.
Optimistic bias
It is often easy to identify where meshing of market and resources from combination could lead to enhanced valueif all goes smoothly. The pitfalls and problems that lie in wait on the way to extracting that value are often lesseasy to identify in advance.
Strategy matching, interdependent strategiesOne feature of mergers and acquisitions is that they often appear in waves not only in the economy, butsometimes in a particular sector even when there is not much activity of this nature in the rest of the economy. Afirm may observe its close rival pursuing a particular strategy (Strategy X) through merger or acquisition.
Our firm may be uncertain as to whether its rival's strategy is wise (adds value) or foolish (does not add value).But, it knows that it can match its rival by doing a similar merger or acquisition move, and so maintain itscompetitive position relative to its rival. The implications for our firm can be seen in the following table.
Whether or not to play fol low th e leader
OUR FIRMRIVAL FIRM
Strategy X turns out to be foo l ish Strategy X turns out to be wise
Does not match
rival
Our firm gainscompetitive edge overrival
Our firm losescompetitive edgeover rival
Matches rival Our firm maintainsits competitiveposition relative to its rival
Our firm maintainsitscompetitive position relative to itsrival
If it is a risk avoider, it will choose the option with the least worst possible outcome, which would be to match itsrival's strategy, otherwise know as the maximin solution. It is important to note that strategy matching may beseen as providing our firm with potential benefits which are not necessarily reflected in added value fromcombination.
Insulation from environmental surprisesThe reason for the acquisition or merger may be that it is a way of diversifying into other markets andtechnologies and generating a related-constrained or even a related-linked strategy. With strategy matching, thebenefit of such insulation may not necessarily be reflected in enhanced profitability since that is not the purpose ofthe exercise.
Agency problems managerial motives for the m ergerIf managerial remuneration and rewards are more closely tied in to the size of the firm rather than itsperformance, then it would be quite rational for management to push for increased growth and size, even ifcombinations to achieve this may dissipate rather than enhance value.
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The Prisoners DilemmaWe saw above that strategy matching may be sensible to prevent foreclosure. However, there may be caseswhere the firms finish up choosing the same value-destroying merger and acquisition strategy even when i t isc lear to both f i rms that they wou ld be better of f i f they could agree not to pu rsue such s tra teg ies.
The real benefit that either firm could extract from making a downstream move is that it gives it a base on which itcould build to foreclose the other firm's market. The downstream stage involves very different skills andcompetencies for the two upstream firms and neither firm has the suitable expertise to manage this stage; indeedthey would destroy rather than add value at this stage. 'OUR FIRM' is the first entry in each box.
The Prisoners dilemma and possible effects of mergers & acquisition
OUR FIRMRIVAL FIRM
Acqui res downs tream Does not acqui re down stream
Acqui res
downstream-10 / -10 25 / -15
Does not acquire
downstream-15 / 25 20 / 20
The fact that the combined profits of the pair have fallen from $40m ($20m + $20m) to $10m ($25m - $15m)reflects the poor fit of the upstream and downstream stages and the fact that overall efficiency has been reduced
by this move.
However, if both firms decide to move downstream, their moves cancel each other out in competitive terms andthey are left with poorly fitting activities in which there is little carryover in competencies from one stage toanother. Efficiency on the part of both firms is impaired by the moves and they now make losses of $10m each.
Clearly, they would have been better off individually and collectively (profits of $20m each) if they had agreed tostick to the stage that their competencies were based in rather than move downstream (losses of $10m each). Ifour firm's rival moves downstream, then it would be rational for our firm to follow and make a loss of only $10mcompared to $15m loss it would make if it stayed put.
If the rival decides not to move downstream, our firm can make a profit of only $20m by doing the same, but couldbeat that with a profit of $25m by integrating and building a base downstream that may help to cut its rival out ofsome of that market.
Whatever its rival does, our firms most profitable strategy is to move downstream. Exactly the same logic holdsfor the rival firm, with the result that both firms move downstream and start to make losses in a sector where theyhad previously been making profits.
A Prisoners' Dilemma structure to a situation can result in merger and acquisition destroying value, even in caseswhere the management are aware of these dangers in advance.
7.4.2 Why Do Acquirers Do Even Worse than Those Being Acquired?
The Grossman-HartGrossman and Hart (1980) showed that dispersion of ownership of the firm amongst a number of shareholderscould create difficulties for take-over bids. If there are a number of dispersed shareholdings in the firm, then each
shareholder may reason that anything any individual does will not affect the chances of the bid going through orfailing.
Each may reason that, rather than sell out, it may be better to hang on and free ride on a full share of theincreased value of the asset once the bid goes through. But if each shareholder reasons the same way, then thebid will fail at least until the price gets to the point where sufficient shareholders reason it will be better to sell thanto hold on. And of course this may be at the price that redistributes all the gains from merger from the acquirer tothe shareholders of the target firm.
The 'Winner's Curse'Suppose that a firm is in play and that a number of potential bidders are interested in acquiring i t. The potentialbidders value what they think this firm is worth and its future prospect. Inevitably the potential bidders make
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errors, some of an overly-optimistic nature and others of an overly-pessimistic nature, thus biasing their estimatesof the present value of this asset.
If the realistic present value of the firm lies below one or more of those based on overly-optimistic assumptions,the winning bid is likely to be based on an overestimation of how much its new acquisition is really worth. Theresult could be eventual disappointment for the 'winning' firm when it discovers that it had an inflated estimate ofthe true worth of its prize in the first place.
The Winner's Curse can distribute gains from acquisition from the owners of the acquiring firm who 'win' the bid tothe owners of the acquisition who find they have been paid more than their asset is realistically worth. This canhold whether or not the combined firm is worth more than the sum of the value of the two separate parts pre-acquisition.
Probably the best defence against the Winner's Curse is natural caution and risk aversion in the face ofuncertainty.
Hubris (or excessive self-confidence)Management involved in a takeover may become so caught up in the thrill of the chase and the excitement of dealmaking that they allow their bids to become unrealistically inflated. Lack of balanced judgement may result in bidprices being pushed up beyond what should be regarded as reasonable.
As far as direction is concerned, stick as close to home as possible if you want to add value, and choose internalgrowth over merger and acquisition (if you have the time and opportunity). The further away from your existing
competencies that a move takes you, the greater the chances that the move will destroy rather than add value.
In practice, merger or acquisition may be chosen over internal growth for a variety of reasons as follows: Growth objectives of management Where speed is important, for example to pre-empt competitive response of rivals To gain competencies and resources that could not be easily developed internally In the absence of room for entry through internal growth (e.g. the existing firms may have the supplier and
customer bases locked up) In order to eliminate a competitor.
Merger or acquisition may be seen as a quick fix to problems that internal growth may find more difficulties indealing with, at least within the time scale envisaged by the management. Even if the merger deliver immediatepay-offs this still leaves the issue whether such a strategy is suited to deliver sustained competitive advantage
over the longer time horizons.
7.5 Co-operative activity
There are a number of ways that firms can co-operate in practice as follows: Licensing Franchising Informal co-operation Sub-contracting Alliances Network participation Joint venture
Al icense is effectively permission for another firm to indulge in an activity that would otherwise be forbidden bylaw. It usually involves the transfer of intellectual property rights in technology for specified periods and territories,in the form of patents, designs, trademarks, etc.
A Franchise involves the transfer of intellectual property from one party to another for specified periods andterritories, usually based around the rights to use the franchisor's name and trademarks, as in the case ofMcDonalds and KFC.
The main difference between licensing and franchising is that licences usually relate to part of a business (thetechnology for a specified product or products). While franchising tends to involve the transfer of know-howranging over the entire business, from purchasing through production to presentation and selling.
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By its nature, in formal co-operat ion is difficult to pin down and define in formal terms; it really depends on thecontext in which it takes place. But the logic of it is clear enough and can be summarised as: 'you scratch myback and I may scratch yours'.
Sub-contract ing involves separating out part of a production process to be dealt with under contract by aseparate firm. They are increasingly assuming more responsibility for R&D and design activities, with the relationbetween buyer and supplier now frequently evolving into long-term co-operation.
Join t ventureis a form of co-operative activity that has increased rapidly in numbers in recent years. Definitionsvary, but generally tend to have these five characteristics:
1. Two or more parent firms agree to co-operate2. The new entity (the 'child') is created for a specified task and possibly duration3. The child has its own decision-making capability4. The child is co-owned by the parents5. There is provision for continuing parental supervision and control over the venture
Merger versus jo in t ventures:
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Joint Venture
A joint venture involves three particular considerations when this alternative is compared to the merger option:
1. Contractu al issues. The joint venture contract between the parties may absorb considerable amounts ofmanagerial and legal resources just to set up. The rights, responsibilities and obligations of the parties willhave to be discussed and agreed. Each party will normally need to police and monitor each other'sperformance and actions. The possibility of opportunistic behaviour may be seen as greater in joint venturecompared to mergers because firms other than your own are involved, adding to the cost of monitoring.
2. Complex hierarchy. Joint ventures can lead to conflict and confusion since there is no reason that theobjectives, priorities and perceptions of the partners as to the outcomes of the joint venture should be thesame. They may also face the incompatibility problem in that procedures and cultures may be very differentin the two parents, leading to further co-ordination problems, miscommunication and misunderstanding.
3. Approp r iab i l i ty prob lems. The fear of losing competitive advantage because it leads to intellectual propertyleaking out is a real one for joint ventures. A great advantage of mergers is that it is more able to keepimportant secrets and technique private by internalising all critical assets. The joint venture may provide director indirect access to the partners techniques and processes. Either firm may permanently acquirecompetencies that it lacked or was weak in.
Firms may naturally fear revealing the basic competencies that drive their competitive advantage, especially ifthere is a danger that their present partner could become a future rival in these areas.
1. Why jo in t venture and not other forms of co-operat ion?
The reason that joint venture may be preferred to other forms of co-operation, such as licensing andfranchising, is that there are often still major strategic decisions to be made involving the venture. These
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other forms of co-operation are more appropriate for cases where the fundamental market and technicalcharacteristics that will help generate competitive advantage are fully known in advance and can effectivelybe specified in a contract. Joint venture is frequently adopted in areas where there is still major uncertaintyconcerning market and/or technical possibilities, such as technological innovation, new market entry andsearching for natural resources.
2. Why jo in t venture and not merger and acquis i t ion?
Joint venture can be designed to cover only the selected range of the resources that are of relevance to thisventure opportunity, and these in turn may relate to only a small part of the relevant partners activities.
There are two basic ways that joint venture can perform:a) Selected pieces o f the value ch ain. Suppose a group of firms were to form a joint venture in sales
only, and keep the rest of their activities separate? This would allow them to set up a decision-makingfacility to co-ordinate potential gains from sharing sales forces, while localising most of the costs of co-ordination to that region of the firm.
In principle, there is no reason why other regions of the value chain could not be picked off and jointventures set up by the two firms in, say, distribution, production, purchasing or R&D.
b) Selected bus inesses of the firm. Suppose a group of firms form a joint venture in the new business,keeping the rest of the firms separate. This would help them set up a decision-making facility to co-ordinate resource sharing over the relevant region of the firm, again localising most of the costs of co-ordination to that region of the firm.
Joint venture is almost certainly more costly than merger or acquisition over the range of the act iv i ty to which i tis appl ied. It is not just an alternative to corporate diversification through merger and acquisition, it is also aconsequenceof it. As long as firms are small and specialised, exploitation of new opportunities through mergerand acquisition is likely to be the preferred route to growth, especially if internal expansion opportunities arelimited.
An al l iance between two firms involves a formal or informal agreement to co-operate on a variety of matters.Alliances can have both resource-based and transaction-cost logic.
The advantage of alliances from a resource-based perspective is that both sets of managerial teams can build upfamiliarity and understanding in terms of how the other firm works.
The transaction-cost logic for alliances is that they should inhibit opportunism. It may be easier to behaveopportunistically for one-off acts of co-operation where the partners do not have any other co-operativeagreements with each other.
Network participation can display some of the features and attractions of joining a club. Networks may existwhere three or more firms are directly or indirectly linked by a series of co-operative agreements. It may be setup by formal agreement, or it may simply evolve without any central set of objectives, direction or planning. Theessential quality of a network is that there are access and transaction cost benefits from joining, over and abovethe benefits which one-on-one co-operative agreements or alliances can provide.
Acquis i t ion may be the best method in securing access to supplies or transferring technological ideas and soadding value. However, profitability is not in itself an acceptable reason for acquiring another firm. Highprofitability would normally be reflected in the present value of the acquisition and the resulting price that has tobe paid for an acquisition, effectively removing the profit incentive for merger.
